Commentary: Financial bailout: Words of caution

This article first appeared in the St. Louis Beacon: September 26, 2008 - At this stage it is imprudent to speculate on the intricate details that the government’s bailout plan will include. There are, however, several broader issues to consider as the plan takes shape.

First, the rescue plan should not be used as an opportunity to extend the role of government in other areas of the economy.

Some advocate using the bailout of financial institutions to help those on Main Street. The editorial page of The New York Times, for example, called for the bailout plan to include an extension of unemployment insurance, increased federal funding to assist state and local governments in providing health care services and increased food stamp funding. Such backdoor attempts to increase government’s reach in the economy should be resisted.

This is not being two faced, either. If the bailout plan is properly structured, the government’s job should be to dispose of the assets it is acquiring back to the private market. Not only does this remove the distressed loans from the banks, it also reduces the final cost to taxpayers. The Resolution Trust Corp. (RTC) was given the task of acquiring and marketing assets from failed savings and loans in the early 1990s. Between 1989 and 1995, the RTC resolved 747 thrifts with assets of nearly $400 billion. Its mission completed, the RTC vanished.

A bothersome outgrowth of this episode is the growing sentiment that free markets inevitably result in economic upheaval. Last year, Christopher Dodd, D-Conn., chairman of the Senate Committee on Banking, Housing and Urban Affairs, reminded attendees at Jesse Jackson’s Wall Street Economic Summit that “Our free nation is in many respects built on our free market economic system. … Through wars, a depression, recession, financial scandal and terrorist attack our national economy has continued to grow.”

In these stressful times, it is tempting to relinquish our economic freedoms to authority. Is that authority more adept at preventing the kind of economic dislocations we are experiencing? Ask those living in the heavily regulated countries that are experiencing the same collapse of housing values and frozen credit markets. We must resist the temptation to replace free markets with the hope that increasingly regulated ones will guarantee stability.

History shows that increasing the labyrinth of regulations that govern financial markets will not prevent future difficulties. Responding to a wave of subprime loan defaults, many major cities and a number of states passed laws restricting the practices of subprime lenders in 2001. Bills were introduced in the U.S. Congress to further regulate the subprime industry and protect borrowers. Even with these protections, many point to the subprime market as the root cause of the financial crisis.

The focus on any new regulations should be on increasing transparency. The fact that not all parties in a transaction possess the same information can lead to undesirable outcomes. Reducing this asymmetric information and the adverse selection it fosters must be a key objective of new guidelines.

Finally, sweeping regulatory changes are not likely to come without unexpected costs. Sarbanes-Oxley was heralded as fixing the failure of markets to rein in corporate malfeasance exemplified by the collapse of Enron and WorldCom. The weight of evidence suggests otherwise. Sarbanes-Oxley has not controlled fraud and mismanagement. Moreover, research indicates that it has significantly raised the cost of doing business, increased the going-private decisions of firms, and pushed some multinational firms to locate in other countries.

The plan must focus on steadying financial markets. This isn’t the time to attach riders to satisfy disparate constituencies. Above all, it isn’t an opportunity to abrogate economic freedom under the cloak of stability.

Rik Hafer is distinguished research professor and chair of theDepartment of Economics and Finance and director of the Office ofEconomic Education and Business Research at Southern IllinoisUniversity Edwardsville.